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Hulbert on Markets

The Irrational Allure of Growth Stocks

By

Mark Hulbert

Updated July 6, 2006 11:59 p.m. ET

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WHICH DO YOU FIND MORE INTOLERABLE?

Losing money when the market declines, or not making as much as the market when it rises?

In my experience, most investors are quick to answer that it is the first of these two scenarios that they would have a harder time enduring. After all, who likes to lose money?

But, according to almost all money managers I talk to, it is the second scenario that -- when push comes to shove -- investors actually can't stand.

This became particularly evident in the late 1990s, when value strategies seriously lagged the overall stock market for several years running. That era was dominated by growth stocks in general and high-tech and Internet-related issues in particular. Money managers reported that it was the very rare client who was willing to tolerate making only a couple of percents per year while the most popular growth stocks were rising by 20%, 30% and more.

Those value-oriented advisers who were willing to stick to their guns enjoyed the last laugh during the 2000-2002 bear market, of course, when their stocks held their own -- or even produced handsome gains -- while the overall market dropped like a rock.

This psychological perspective on investing helps to explain what otherwise is a mystery: Why growth stocks continue to be so much more popular than value stocks. (Indeed, the lion's share of investment newsletters in this country focus on growth stocks.)

Value strategies historically have produced higher long-term returns than growth strategies, while at the same time losing a lot less during bear markets. On paper, at least, that would appear to make following value strategies a veritable no-brainer.

The missing ingredient that resolves the mystery is a psychological factor that might be called "keeping up with the Joneses." Because of this factor, investors find value strategies to be significantly riskier than growth strategies.

Why doesn't "keeping up with the Joneses" work against growth strategies during bear markets, when value strategies typically are performing much better? It may to some extent. But investors tend to stay quiet about their losses, and only brag when they are making the big bucks. It's easier to lose money when others are losing than it is to lag the market when everyone else appears to be winning big.

This is what John Maynard Keynes had in mind when he wrote that it is better for one's reputation to fail conventionally than to succeed unconventionally.

Quantifying this psychological dimension is not easy, however. But earlier this month I came across an intriguing way of doing so: Focus on how a strategy performs in those months when the overall market is performing the best.

This approach was discussed in the June 30 edition of the "Investment Review" that is published by Ford Equity Research. This advisory service falls closer to the value end of the growth-versus-value spectrum than most of the newsletters tracked by the Hulbert Financial Digest (HFD).

Indicative of this orientation is its performance since the beginning of 2000, close to the top of the bull market: Over the six and one-half years from then until mid-June, according to the HFD, its recommended stocks produced a gain of 10.6% annualized, versus a total return of just 0.3% annualized for the Dow Jones Wilshire 5000 index.

In its latest issue, Ford Equity Research focused on just those months over the last decade in which the average stock rose by at least 5%. They presumably were those months in which the "keep up with the Joneses" factor would have been felt the most strongly.

Ford Equity Research then measured how each of a number of different stock selection strategies performed during these months. Not surprisingly, momentum stocks shone. Such stocks are those that, at any given time, have performed the best over the trailing several months, of course, and they tend to continue outperforming for a while longer -- to exhibit momentum, in other words. In 97% of these months on which Ford focused, momentum stocks outperformed the overall stock market.

No wonder momentum strategies are so popular. They almost always perform well during those periods when investors' psychological desire to beat the market is strongest.

At the opposite end of the spectrum, consider stocks picked according to Ford Equity Research's value strategy, which is proprietary. They outperformed the overall market in fewer than half the months in which the market was strongest. In fact, on average, stocks picked according to Ford's value model actually lost money during these months in which the overall market performed so well.

Despite performing so poorly during these months, however, value stocks performed wonderfully over the entire period that Ford focused on in its study. In fact, they had the best overall performance of any strategy that Ford measured. That's because momentum stocks performed particularly poorly when value stocks did well.

So there's the trade-off: On the one hand is a momentum strategy that performs extremely well when the market is hot, but requires followers to tolerate big losses when the market is falling. And on the other is a more value-oriented strategy that produces mediocre returns at best when the market is hot but shines when the market is falling.

My 26 years of tracking investment newsletters has inclined me to believe that neither approach is better than the other. Choosing between them depends on taking this crucial psychological dimension into account.

If you are someone who finds it intolerable not to "keep up with the Joneses" when the market is hot -- and there is no shame in admitting that this is the case -- then you should be a growth-stock investor.

But if, in contrast, you are someone who is willing to be a market laggard when the market as a whole is going crazy, then value investing is probably the way to go. You most likely will be rewarded with superior long-term results.

Mark Hulbert is founder of The Hulbert Financial Digest. He is a senior columnist for MarketWatch.

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